"This leaked Troika "debt sustainability analysis" submitted to the EU Summit yesterday will no doubt be a part of the deliberations in the Greek debt restructuring proposals to be hammered out by Oct. 26th.

Point 1. A. on the first page is a pretty open and blatant admission that expansionary fiscal consolidation (EFC) has proven to be a contradiction in terms, at least in Greece. Moreover, there is a serious policy incompatibility problem, at least over the intermediate term horizon, with efforts at internal devaluation (ID) - that is, attempting nominal domestic private income deflation in order to improve trade prospects when one has a fixed exchange rate constraint.

This latter point is further amplified in the "stress test" scenario discussed on the bottom of page 5, which I think we all know is soon to become the Troika's base case scenario. They stop short of recognizing that their demands and the actions they have imposed on Greek policymakers are setting off a Fisher debt deflation implosion of the Greek economy. But clearly, the EFC policy is rupturing any semblance of a social contract, and ripping the social fabric to shreds as well.

This is a very large step for the Troika to have taken; admitting that EFC is not working, and that pursuing internal devaluation will aggravate matters further, including the ability of Greece to hit fiscal targets, is a fairly large step in the recognition of the reality of the situation. This is not something that Troika economists are often prone to do. It is not what their incentive structures, formal and informal, tend to encourage them to do.

More importantly, this admission by the Troika shows the rest of the periphery, the UK, the US, and even Japan that the road to debt deflation hell is paved with good intentions - intentions the Troika appears even now prepared to question - but of course, only in the very special conditions of Greece.

We must argue Greece is not a special case, but rather a case in point of what happens when you impose fiscal consolidation on countries with high private debt to GDP ratios, high desired private net saving rates, and large, stubborn current account déficit.

With this document, now it is evident that analysts at the EU, the IMF and the ECB understand these points as well."

EL TRILEMA EUROPEO

This leads to a vicious circle: recapitalisations undermine the creditworthiness of governments and this then feeds back in to the banks, which see the value of their assets (government bonds) decline further. The more governments recapitalise, the more the value of the banks’ assets falls, leading to the need for further recapitalisations.

To stop the downward spiral a floor has to be put on the price of government bonds in the eurozone and the European Central Bank is the only institution capable of implementing it. To prevent further drops in government bond prices, the bank should announce that it is ready to intervene in the market. The ECB is the only institution capable of doing this because it can create money without limit. In announcing its unconditional commitment, the bank would stop the spiral of decline. And when investors were convinced of the resolve of the ECB, they would stop selling sovereign bonds because they would trust that a floor had been put on their prices.

The ECB has no excuse not to act. In trying to keep its monetary virginity intact, the bank threatens to destroy the eurozone. If that happens, nobody will be able to profit from its virginity.

The €200bn will apparently be used to insure future purchasers of Italian and Spanish bonds against the first tranche of any losses they may suffer in a sovereign default. If the first 20 per cent of losses are insured, the EFSF could cover €1,000bn of bond purchases.

The key question is whether this would be a sufficient inducement to bring a large amount of fresh capital into the troubled bond markets. The subsidy would be worth 180 basis points on new Italian bonds, according to Andrew Bevan, Fulcrum’s bond specialist, given the market’s assumption that a sovereign default is 40 per cent likely over the next five years, and assuming that there would be a 50 per cent recovery to bond holders after that default.

It is not clear that this will be enough to transform the market’s perceptions of government debt in these struggling economies. The eurozone could increase the incentives to future bond purchasers by increasing the insured amount of any future loss from 20 per cent to (say) 40 per cent. But that would automatically reduce the amount of bonds covered from €1,000bn to a modest €500bn.

At its absolute maximum, the subsidy can never be worth more than €200bn, which is equal to 8 per cent of the current outstanding debt of Italy and Spain. The eurozone cannot make this subsidy any bigger by using the smoke and mirrors involved in leverage. Talk of trillions of new money, apparently conjured out of thin air by financial engineering, is inherently misleading.

If this is Germany’s final word, then the fund will remain too small, and the eurozone will once again discover that it cannot make a silk purse out of a sow’s ear.

First, external deficits mean that residents are spending more than their income and financing the difference abroad. If creditors decide such borrowers are no longer creditworthy (be they private or public), they will cut them off, thereby causing a recession and a plunge into – or deepening of – fiscal deficits. Second, prolonged external deficits also shape the structure and competitiveness of an economy.

Third, sustained deficits lead to huge net external liabilities, often intermediated by banks. When the external lending halts, the banks are likely to implode, undermining both the economy and the fiscal position. As Goldman Sachs notes, the inability to devalue also rules out a way of adjusting net liability positions that has proved helpful to the US and UK. Worse, the only available mechanism – an “internal devaluation” (or falling domestic price level) – will make the burden of external debt even greater. The improvement in the current account balance must then be even bigger than it would otherwise need to be.

Most important of all, people care about what happens to their own country. The inhabitants of a depressed member country will hardly console themselves with the thought that others are booming.

Inside the eurozone, adjustment of imbalances remains essential. But it is also vastly difficult, because the exchange rate has gone. In its place, comes adjustment via depression and default. A currency union with structural mercantilists in the core now threatens a permanent slump in the periphery. Solving that is the true cure. Can it be done? I wonder.

Sunday, October 9, 2011

SATYAHIT DAS: EL MOMENTO DE LA VERDAD

Current concerns, most readily observable in wild gyrations of equity prices, are driven by the identified concerns but also the lack of credible policy options.

The most likely outcome is a protracted period of low, slow growth, analogous to Japan’s Ushinawareta Jūnen – the lost decade or two. The best case is a slow decline in living standards and wealth as the excesses of the past are paid for. The risk of instability is very high; a more violent correction and a breakdown in markets like 2008 or worse are possible. Frequent bouts of panic and volatility as the global economy deleverages –reduces debt- are likely. Problems created gradually over more than the last three decades can only be corrected slowly and painfully.

The eerie sound of the stick shaker can sometime be heard on cockpit voice recordings of doomed flights just before they crash. The global economy’s control stick is shaking violently. It remains to be seen whether the economic pilots can regain control and land the flight safely or whether it ends in a crash.

Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (August 2011)